Main Causes of Inflation Derived by Economists

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Three main causes of inflation derived by economists are as follows: 1. Cost-push Inflation 2. Demand-pull Inflation 3. Monetary Inflation!

Inflation is not a random increase in the general price level. While examining the causes of inflation, therefore, it is necessary to consider the reasons for a rise in the price level over a period of time. Economists divide the causes into three main categories.

These are cost-push, demand- pull and monetary. The consequences of inflation can not only be influenced by its cause, but also its rate, inflation rates of other countries and the action taken by the government to offset its effects.

1. Cost-push Inflation:

Cost-push inflation occurs when the price level is pushed up by increases in the costs of production. If firms face higher costs, they will usually raise their prices to maintain their profit margins. There are a number of reasons for an increase in costs.

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One is wages increasing more than labour productivity. This will increase labour costs. As labour costs form the highest proportion of total costs in many firms, such a rise can have a significant impact on the price level. It will also not be a one-off increase. The initial rise in the price level is likely to cause workers to press for even higher wages, leading to a wage-price spiral.

Another important reason is increase in the cost of raw materials. Some raw materials, most notably oil, can change the price by large amounts. Other causes of cost-push inflation are increases in indirect taxes, higher cost of capital goods and increase in profit margins by firms.

Cost-push inflation can be illustrated on an aggregate demand and aggregate supply diagram. Higher costs of production shift the AS curve to the left and this movement forces up the price level, as shown in Fig. 1.

2. Demand-pull Inflation:

Demand-pull inflation occurs when the price level is pulled up by an excess demand. Aggregate demand for a country’s products can increase due to higher consumption, higher investment, higher government expenditure or higher net exports. Such an increase in aggregate demand will not necessarily cause inflation, if aggregate supply can extend to match it.

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When the economy has plenty of spare capacity, with unemployed workers and unused machines, higher aggregate demand will result in higher output but no increase in the price level. If, however, the economy is experiencing a shortage of some resources, for example – skilled workers, then aggregate supply may not be able to rise in line with aggregate demand and in­flation occurs. In a situation of full employment of resources it would not be possible to pro­duce any more output. As a result, any rise in demand will be purely in­flationary as shown in Fig. 2.

3. Monetary Inflation:

Monetary inflation is a form of demand-pull inflation. In this case, excess demand is created by an excessive growth of the money supply. A group of economists, appropriately called monetarists, believe that the only cause of inflation is the money supply increasing faster than output. They argue that if the money supply increases, people will spend more and this will lead to an increase in prices.

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In explaining their view, monetarists examine the relationship between the money supply and the velocity of circulation on one hand and the price level and output on the other. By definition, both sides must be equal as both represent total expenditure.

For example, if the money supply is $100bn and, on average, each dollar changes hands four times, a total of $400bn will be spent. If an output of $200bn products is produced, the average price would be $2 (200bn x $2 = $400bn). If the money supply increases by 50% to $150bn and output and the velocity of circulation remain unchanged, the average price would rise to $3 ($150bn x 4/200bn).